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Ratio Note

The document provides an overview of various financial ratios used for ratio analysis and interpretation, including gross profit margin, operating profit margin, current ratio, quick ratio, and others. It explains how these ratios help assess a company's profitability, liquidity, and operational efficiency, as well as the implications of different ratio values. Additionally, it discusses strategies for improving working capital and managing trade receivables and payables.

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12 views14 pages

Ratio Note

The document provides an overview of various financial ratios used for ratio analysis and interpretation, including gross profit margin, operating profit margin, current ratio, quick ratio, and others. It explains how these ratios help assess a company's profitability, liquidity, and operational efficiency, as well as the implications of different ratio values. Additionally, it discusses strategies for improving working capital and managing trade receivables and payables.

Uploaded by

flawlessshiro
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Ratio Analysis & Interpretation

Higher >>>>>>> Better


Higher …………..Better
It compares the gross profit of a company to its net sales to show
how much profit a company makes after paying its cost of goods
sold.
GP > 40% -----------------------Long-lasting competitiveness
< 40%-------------------------- higher competition
< 20%-------------------------- extremely higher competition
Operating Profit margin measure of how much profit a company makes
after accounting for operating expenses.
Net profit margin measure of how much profit a company makes after
accounting for all expenses.
Current Ratio
This measures the ability of a business to meet its current liabilities when
they fall due.Ratios between 1.5:1 and 2:1 are generally regarded as
satisfactory,but it is important to consider the size and type of business.
If the current ratio is over 2:1 it may indicate poor management of the
current assets.
Generally, a current ratio below one may be a warning sign that the
company doesn’t have enough convertible assets to meet its short-term
liabilities.
>2:1 ------------------------- Poor management on Current Assets /
overcapitalization (undertrading)
<2:1 -------------------------Undercapitalization (overtrading)
Working Capital:
Working capital = Current assets – Current liabilities
Low working capital may indicate that the company will have difficulty
meeting its financial obligations. Conversely, a very high amount may be
a sign that it’s not using its assets optimally.
The working capital of a business must be adequate to finance theday-to-
day trading activities. A business which is short of working capital may
encounter the following problems:
• cannot meet immediate liabilities when they are due
• experience difficulties in obtaining further supplies on credit
• cannot take advantage of cash discounts
• cannot take advantage of business opportunities when they arise.

Ways to improve the working capital position include:


• introduction of further capital by the owner(s)
• obtaining long-term loans/non-current liabilities
• selling surplus non-current assets
• delaying purchasing non-current assets
• increasing profit
• reducing drawings by the owner(s) (or reduction in dividends).
The actual cash position can also be improved by measures such as
delaying payments to credit suppliers, increasing the proportion of cash
sales, and reducing the period of credit allowed to credit customers.
These measures may also have some adverse effects such as the refusal
of further supplies on credit, customers moving to other suppliers where
longer credit is allowed, and so on.
Quick Ratio(Acid Test)
The quick ratio is a liquidity risk KPI that measures the ability of a
company to meet its short-term obligations by converting quick assets
into cash.
This is a similar calculation to the current ratio, but the liquid (acid test)
ratio excludes inventory as this is not regarded as a liquid asset. Inventory
is two stages away from being money: the goods have to be sold and then
the money has to be collected from the debtors.

Ratios between 0.7:1 and 1:1 are usually regarded as satisfactory, but, as
with the current ratio, the size and type of business should also be
considered.
A ratio of 1:1 indicates that the immediate liabilities can be met out of the
liquid assets without having to sell inventory.
If the liquid (acid test) ratio is over 1:1 it may indicate poor management
of liquid assets such as having too high a balance on a bank current
account.

>1:1 ------------------------- Overcapitalization (undertrading)


<1:1 ------------------------- Undercapitalization (overtrading)
Rate of inventory turnover
This ratio calculates the number of times a business sells and replaces its
inventory in a given period of time.
The rate of inventory turnover can affect the profit of the business. If
business activity slows down both the gross profit and the profit for the
year will be adversely affected.

(Times) High >>>>> better (less inventory or stronger sales)


Low >>>>> not good ( high inventory level or weak sales)
A lower rate of inventory turnover can be caused by factors such as:
• lower sales (resulting in higher inventory levels)
• inventory over-purchased
• too high selling prices
• falling demand
• business activity slowing down
• business inefficiency.
Trade Receivable Turnover (Customer collection period)
It uses to measure how quickly its customers pay their bills. It is the
average number of days required to collect accounts receivable
payments. A lower value means customers are paying faster.
The answer to this calculation – the length of time credit customers
actually take to pay their accounts – should be compared with the term of
credit allowed to them.
( Days ) >>>> Low >>>> Faster >>>> better
High >>> Slower >>>> greater risk
The quicker the customers pay their accounts, the better it is; the money
can then be used for other purposes within the business.
The longer a business has to wait for a debt to be paid the greater the
risk of it becoming irrecoverable.

If the period decreases it may indicate that the credit control policy is
being applied more effectively: if the period increases it may indicate that
the credit control policy is inefficient, or that longer credit terms are being
allowed in order to maintain the quantity of credit sales.
The rate of the trade receivables turnover can be improved by measures
such as:
• improving credit control policy (sending regular statements of
account, ‘chasing’ overdue accounts and so on)
• offering cash discount for early settlement
• charging interest on overdue accounts
• refusing further supplies until any outstanding debt is paid
• invoice discounting and debt factoring.*
Trade Payable turnover (Supplier payment period)
It measures the average time taken to pay the accounts of credit
suppliers. The answer to this calculation should be compared with the
term of credit allowed by the suppliers.
If the period decreases, the business is paying the suppliers more quickly;
if the period increases it may indicate that the business is short of
immediate funds and is finding it difficult to meet debts when they fall
due.
This ratio can also be influenced by the trade receivables turnover: if
the credit customers do not settle their accounts promptly the business
may not be able to pay the credit suppliers promptly.
Taking longer to pay the suppliers means that the business can use the
funds for other purposes, but there can be adverse effects such as:
• the supplier refusing credit in the future
• the supplier refusing further supplies
• the loss of any cash discount for early settlement
• damage to the relationship with the supplier.
Debt-to-Equity Ratio:
This ratio looks at a company’s borrowing and the level of leverage. It
compares the company’s debt with the total value of shareholder’s
equity. A high ratio indicates that the company is highly leveraged. This
may not be a problem if the company can use the money it borrowed to
generate a healthy profit and cash flow.
If >50% --------------------------- need to find a resonable solution.
It also reflects a business's capacity to raise additional capital through
long-term loans.
A lower ratio signifies greater creditworthiness, enabling the business to
access financing more easily.
Using borrowed capital is favorable when interest rates are lower than
the returns generated by deploying those funds in the business.
Interest cover ratio (times interest earned ratio)
A long-term solvency KPI, interest coverage quantifies a company’s ability
to meet contractual interest payments on debt such as loans or bonds. It
measures the ratio of operating profit to interest expense; a higher ratio
suggests that the company will be able to service debt more easily.
5 times --------------- better
Earning per share
It estimates how much net income a public company generates per
share. It’s typically measured by the quarter and by the year. Analysts,
and investors often use EPS as a key measure of a company’s profitability
(earning quality) and performance.
High ratio --------- increase the share price of the company.
A company with a high EPS is capable of generating a significant dividend
for investors, or it may plow the funds back into its operations to
generate more growth

Dividend per share


Earnings are distributed to shareholders as dividends, but some earnings
are retained to ensure future growth.

P/E ratio
The greater the P/E ratio, the greater the demand for the shares.

Dividend covered ratio


It shows the number of times the dividend has been covered by the
profits (earnings) of this year. It could be said that the higher the dividend
cover, the ‘safer’ is the dividend. On the other hand, it could be argued
that a high dividend cover means that the company is keeping new
wealth to itself, perhaps to be used in buying new assets, rather than
dividing it among the shareholders.
If, therefore, the dividend is said to be three times covered, it means that
one-third of the available profits is being distributed as dividends.

Dividend yield
The dividend yield is a very simple ratio comparing dividend per share
with the current market price of a share. It indicates the relationship
between what the investor can expect to receive from the shares and the
amount which is invested in the shares. Many investors need income
from investments and the dividend yield is an important factor in their
decision to invest in, or remain in, a company.

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